Explaining the earnings yield

With the month of April soon coming to an end, most companies listed on the Malta Stock Exchange (“MSE”) that have a December year-end published their annual financial statements. This is in line with the MFSA Listing Rules that stipulate that a company needs to publish and make available an Annual Report and audited financial statements within four months from the end of the financial period.

So far, 14 out of the 19 companies that have a December year-end published their 2018 annual financial statements with the remainder doing so over the next few days. The remaining 5 companies which are listed on the Regulated Main Market (“Official List”) – namely Simonds Farsons Cisk plc, Trident Estates plc, PG plc, Santumas Shareholdings plc and MaltaPost plc – all have a different accounting reference date. In May, Farsons and Trident will be publishing their annual financial results for the year ended 31 January 2019. In August, PG and Santumas will issue their financial statements as at 30 April and in December, MaltaPost issue their full-year results for the financial year ending in September.

The earnings reporting season is a very important period for the local investing community as it provides a broad assessment of the financial performances of the various reporting companies and, more importantly, indications of the immediate outlook and financial prospects. After the reporting season, many investors may consider changes to their investment portfolios in order to earn more attractive returns compared to the very low deposit rates currently on offer by local banks reflecting the prevailing record low interest rate scenario in the eurozone.

The main objective for the majority of Maltese investors is that of generating a sustainable income stream from the various securities within their investment portfolios. While most investors have a general tendency to favour bonds, a growing number of investors have been realising the benefits of also including an exposure to dividend-yielding equities in their investment portfolios to supplement the interest income they receive from their various bond exposures. This trend has especially been in evidence in recent years and is reflected in the increased turnover on the secondary market for local equities which, for each of the past four years, amounted to close to or above €80 million per annum.

Although many Maltese investors view an investment in equities from a dividend perspective, others seem to forget that the more important objective for investing in equities is that of capital growth over a long period of time. When buying shares and in effect becoming an owner of a company, the focus should be on the creation of long-lasting growth enhancing measures that ultimately translate into the generation of shareholder value.

While the conventional measures for equity-based investors are the price-to-earnings multiple, the price-to-net asset value or the Enterprise Value-to-EBITDA multiple, the earnings yield is a metric that is often overlooked by local investors. The earnings yield shows the yield (or the return) that the company generates when compared to its market value and is calculated by dividing the earnings per share of a company by its share price. It is basically the inverse of the price-to-earnings multiple and illustrates the percentage rate of return that an investor gets when investing in an equity.

Sometimes, investors may not consider the difference between the earnings yield and the dividend yield as a company may elect to distribute most or all its earnings to shareholders as cash dividends. In this case, the dividend yield would be very close to the earnings yield, indicating that the company has a generous payout ratio. For example, the equity of Main Street Complex plc currently offers a net dividend yield of 2.6% and an earnings yield of 2.9%, reflecting the company’s “objective to distribute a total dividend … equivalent to the distributable profits earned during the year” as stated in the IPO Prospectus dated 23 April 2018. Similarly, BMIT Technologies has a very high dividend payout ratio policy and indeed the forecasted net dividend per share of €0.022 for the 2019 financial year translates into a dividend yield of 4.1% based on the current share price of €0.535 whilst the forward earnings yield is 4.7% based on the projected earnings per share of €0.025.

In other cases when a company distributes dividends in excess of its earnings, the dividend yield would be higher than the earnings yield. A case in point is Mapfre Middlesea plc which is recommending the payment of a final ordinary net dividend of €9 million for the 2018 financial year apart from a special net dividend of €8 million. The ordinary dividend is higher than the net profit of €8.59 million generated by Mapfre Middlesea in 2018. In fact, the equity is currently offering a net dividend yield of 4.1% (based on the final ordinary dividend) compared to the earnings yield of 3.9%.

The earnings yield is often used for gauging the attractiveness of investing in an equity when compared to other asset classes. In fact, it is common to find international financial analysts commenting on the earnings yield of the S&P 500 index for example (which currently stands at approximately 4.6%), comparing this to the benchmark yield of the 10-year “risk-free” US Treasury (presently at 2.6%) and arguing whether the spread between the two rates of around 200 basis points is sufficient to cover the higher risks associated with investing in equities. Moreover, the earnings yield can provide investors with an indication of market valuation. For instance, if the earnings yield of the S&P 500 is less than the 10-year US Treasury yield, equities (in general) may be considered to be overvalued. Conversely, if the earnings yield climbs much higher than its historic average, the equity market may be considered to be relatively undervalued.

The earnings yield has widespread scope for application to the local market as it provides additional perspectives and draws attention to investment opportunities that would otherwise be largely undetected. A clear example is Lombard Bank Malta plc. Lombard’s equity is offering a net dividend yield of only 1.4% which, in turn, is not attractive when taken in isolation and when compared to the average gross yield of 1.04% on the 10-year Malta Government Stock (“MGS”). On the other hand, the earnings yield of 8.4% of Lombard is attractive and certainly provides space for deeper analysis rather than just limiting an investment decision to a single metric like the dividend yield or the more conventional valuation multiples.

A similar example is Simonds Farsons Cisk plc which based on the current share price of €9.00 offers a net dividend yield of 1.3% but an earnings yield of 5.3%. The latter is also much higher than the current median earnings yield of 3.9% for all companies listed on the MSE’s Regulated Main Market. Nonetheless, the median earnings yield of 3.9% also includes the performances of those companies which results are notoriously distorted by “one-off” items, like in the case of Malta Properties Company plc and Malita Investments plc through the yearly changes in the fair value of investment properties, and by loss-making companies like Medserv plc.

Among the large companies by market capitalisation, Bank of Valletta plc has the highest earnings yield of 7.4% mainly as a result of the sharp decline in the share price over recent months while the bank remained profitable in 2018 despite the significant litigation provision of €75 million. Nonetheless, a high earnings yield should not be immediately interpreted as a sign of an attractive investment proposition but rather it should be seen together with other valuation metrics (such as the price-to-net asset value) and financial indicators like the return on equity. Similarly, despite the considerable contraction in profitability over recent years, the equity of HSBC Bank Malta plc offers an earnings yield of 4.6% which is higher than the median yield of 3.9% for all companies listed on the Regulated Main Market. In contrast, the earnings yield of GO plc, Malta International Airport plc and FIMBank plc are all below the median rate. GO offers an earnings yield of 3.8% based on a share price of €4.90. However, as the equity begins to trade without the entitlement to the total net dividends of €0.55 per share as from 25 April 2019, the share price is likely to adjust downwards and thereafter result into a higher earnings yield. Conversely, although the earnings yield of MIA (3.4%) and FIMBank (3.2%) are lower than the current median of 3.9%, both offer a spread of over 200 basis points over the average gross yield of 1.04% on the 10-year MGS.

The focus on the income-generating aspect of investing is likely to remain very high on the agenda of local investors for many years to come. This is partly a reflection of general preference which is also dictated by demographical needs in a period where interest rates are expected to remain very low for the foreseeable future. Nonetheless, the local investing community also needs to become more sophisticated, and this includes taking investment decisions that consider a wider variety of ratios and metrics in order to better evaluate the investment case in an equity especially in view of the expected growth in the number of equity listings on the MSE Regulated Main Market in the coming months and years.

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